Expert Commentary: Don’t Be Fooled By U.S. ‘Production Gains’

• WTI sold off to a low of $41.04 this week, capping a $10.63 drop since June 9th. In our view the short-term bearish narrative of too much oil, too much gasoline, weak refiner demand and a worsening macro backdrop creating a stronger U.S. dollar still holds water and it seems likely that oil will break $40 in the near future. On a longer horizon, however, we continue to believe that WTI in the $30s is a buy given the gradual trend towards market balance and the likely flood of capital that a ‘3 handle’ would introduce from the long side. With regards to timing we see the current shift lower in prices to be near its 7th inning and would look to buy $5-$10 wide call spreads for X16 or Z16 expiration on further weakness.

• One of the key items to our view that oil is a buy below $40 is our belief that U.S. production data has falsely compounded bearish oil market sentiment with three consecutive weeks of output gains and five straight weeks of rig increases. At first glance these numbers suggest a signal of health and happiness amongst U.S. frackers. A closer look, however, reveals that Alaska’s output rebound from June disruptions - not frackers in major shale plays - is generating the production gains in the U.S. Crude oil production in the Lower 48 states has declined for 25 straight weeks and overall U.S. output still has significant work to do before finding a bottom. According to their July Short Term Energy Outlook the EIA sees U.S. production averaging 8.6m bpd in 2016 which implies a forecast of about 8.25m bpd in 2H’16. Given the current level of U.S. production at 8.5m bpd this suggests traders should be prepared to see significant supply declines in the coming months unless the EIA is massively wrong in their short-term forecasting. We feel that the tightening shale supply story alongside a gradual move towards balanced daily supply/demand will re emerge as a bullish force for the oil market in coming months.

• Away from the oil market the U.S. Fed put the brakes on a recently bullish U.S. dollar move by offering a more positive view on the economy without hinting at any hawkish moves in the near term. Our view remains that the U.S. Fed will work to talk the dollar down possibly via discussion of helicopter money (as Cleveland Fed President Meester did earlier this month) and that a runaway USD is unlikely to emerge as an overwhelmingly bearish force for oil.

Spreads still weak, but short covering is a positive sign

WTI U16/Z16 bounced from a low of -2.31 this on Tuesday to over -2.10 on a rush of short covering from funds and trade groups. The bounce came despite Cushing’s largest w/w build since May (1.1m bbls,) the U.S.’ first crude stocks gain in eleven weeks and sharp drop in U.S. refiner demand due to weak cracks which have yet to show signs of a rebound. Further back in the curve WTI Z16/Z17 behaved similarly moving from -4.58 to -4.35. We’re currently interpreting the strength of spreads at these levels (70 cents contango for 1-month 4Q’16 strips, 35 cents contango for 1-month Cal ’17 strips) as a bullish sign that the steep part of the move lower for WTI spreads has likely been submitted as spreads climbed in the face of more negative news.

Prompt Brent spreads moved sharply lower this week with Brent U16/Z16 touching -1.70 on Thursday for a 50-cent drop in about 24hrs. The bearish move came despite Libya’s NOC and national government failure to reach a deal which would have reopened Ras Lanuf, Es Sider and Zueitina (Reuters.) Some of the weakness was attributed to positioning for U16’s expiration later today. In Cal ’17 Brent Z16/Z17 got a bounce from short covering moving from -4.69 to -4.40.

Hedge funds sell oil into three month lows

Speculators continued to aggressively sell NYMEX WTI and ICE Brent, according to the most recent batch of COT data. For NYMEX WTI, net length was cut by more than 20k contracts w/w and is lower by 37% since late April. Gross shorts in NYMEX WTI have grown by more than 2.5x from May 31st through July 19th. For ICE Brent, net length has been cut by 29% since Late April and gross short positions have grown by 3x since mid-May.

Money flows into the USO have been flat over the last 3-4 weeks but our suspicion is that more weakness in WTI will invite large inflows into the fund. We also expect to see significant liquidation of short positions as well as new length in the market from Managed Money if oil dips below the $36-$37 area due simply to fear of missing the next opportunity to buy ‘cheap’ crude.

Volatility jumps back to 4-week highs

Crude oil option premiums shot higher this week as WTI dipped below $42 for the first time since April. For WTI U16 at-the-money option volatility traded near 39% Wednesday afternoon for an increase of 4% w/w. As for skew, 25 delta puts traded at 42% while 25 delta calls implied 38%. Realized volatility (20-day basis) sank to 40% and is lower by 15% since July 13th.

DOE stats go from bad to really bad

• Crude oil and gasoline stocks both expanded w/w while refiner runs were cut sharply. That isn’t supposed to happen in late July• Refining margins in the U.S., Europe and Asia remain extremely weak and continue to drive the bearish short-term case for oil• Cushing stocks added 1.1m bbls for their largest weekly build since May

U.S. crude oil stocks increased by 1.7m bbls w/w which was a much larger build than the market had anticipated. Overall stocks at 521m bbls are higher y/y by 13%. PADD II stocks added 674k bbls (+8% y/y) while PADD III stocks added 1.5m bbls (+17% y/y) following an import increase into the USGC of 504k bpd. Overall U.S. crude imports are higher y/y by 8.7%. Stocks in Cushing added 1.1m bbls and production jumped for a third straight week to 8.5m bpd.

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U.S. refiner inputs dropped by an extremely bearish 277k bpd w/w and are lower y/y by 1%. PADD I continues to drive the dip in refiner demand with an 8% y/y deficit in inputs. As of Wednesday afternoon the WTI 321 crack, RBOB/brent crack and gasoil/Brent cracks traded at $13.5/bbl, $12 and $8/bbl for +5yr seasonal lows which suggests to us that more disappointing input data lies ahead.

RBOB futures continued to selloff this week hitting a low of $1.3035/gl on Wednesday for a 36 cent loss since May 24th and breaking below its 200-DMA for the first time since April. RBOB spreads, however, moved sharply higher in the front of the curve despite the overall build of gasoline stocks and build in PADD IB. RBOB Q16/U16 hit a 1-month high at +0.90 cpg on Thursday and is higher by about 2.5 cpg in the last three weeks.

Heating oil futures continued to move lower this week hitting $1.2694/gl on Thursday to cap a 30-cent selloff since June. The low print was just 58 tics above the 200-DMA for heating oil which hasn’t been broken on the downside since May. Spread markets also reacted bearishly to the continued building of inventories in PADDIB and Heating Oil Q16/U16 reached contract lows at a contango of -2.8 cpg.

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Prompt gasoil spreads were generally quiet this week with the front 1-month diff running near a contango of near $6/t. Singapore middle and light distillate stocks increased by 858k bbls w/w and are higher y/y by 6%. In Europe, gasoil stocks in the Amsterdam, Rotterdam + Antwerp hub fell by 145k tonnes and are in line with their seasonal levels from last year.

I think it's all about the imports. Demand is strong, and with another price drop, it'll get stronger. But, some refiners felt that there was easy money to be made from driving season in the USA and they flooded the US market. There's no telling when this flood of imports will start to dry up, and the instant it does, everyone is gonna start freaking out when big draws start showing up in API and EIA data and the boat will have been missed on the next run up.